Failing to conduct proper regulatory due diligence can be likened to failing to conduct a proper home inspection before purchasing a home. We have all heard of home buyers who purchase what they think is their dream home, only to experience a nightmare as the hidden faults behind the walls begin to emerge. Those in the health and food products industries (including the emerging cannabis industry) would do well to learn from the plight of home purchasers. Failure to conduct proper due diligence will inevitably lead to a very expensive version of buyer’s remorse.

WATCH: Do Your Due Diligence—Step 1 in Merger & Acquisition Ventures (01:44)

We normally think of regulatory due diligence with respect to mergers and acquisitions, but it can, and should, also be considered with respect to (i) purchasing a particular product line or brand, (ii) onboarding a particular supplier or vendor, or (iii) to any venture capital investment in general.

In one high profile example from 2016, GNC Holdings Inc. came to a costly settlement with the US government over the sale of illegal dietary supplements, during which time GNC contended that its supplier, USP Labs, had provided “false assurances” about its products. As part of the settlement, GNC agreed to conduct more “due diligence” on its vendors. Of course, due diligence is most effective when applied proactively, rather than retroactively.

GNC Pays $2 Million Fine, Settles Allegations Of Selling Misbranded Supplements https://t.co/bJJiyvVOnc pic.twitter.com/PUy8TjwXap

— David Martin (@DavidMartin0089) December 10, 2016

The health and food product industries, like most regulated sectors, face unique challenges when it comes to due diligence because, in addition to the financial, legal, and commercial considerations, regulatory considerations become particularly important. Failure to conduct proper due diligence can generally result in an overestimation of the value of an asset or an underestimation of the liability of an asset.

Risks of Improper Regulatory Due Diligence

1. Delays or cancellation of product launches (for example, if the mandatory product or facility licencing or registration are not in place)
2. Having to rebrand products (for example, if advertising related to the branding violates marketing authorizations, or if health claims are not substantiated)
3. Costs of coming into compliance (for example, having to invest in new equipment, facility infrastructure, or new staffing, or having to incur unanticipated product testing costs)
4. Increased market liability (for example, recalls)
5. Increased exposure to government enforcement (for example, warning letters, product seizures, and embargoes)
6. Increased exposure to civil suits, due to product failures, false claims, or adverse reactions
7. Failure to meet commitments to third parties, who may conduct their own regulatory due diligence

The key is to conduct proper due diligence. For highly regulated industries, this presents unique challenges. Whoever is entrusted with the undertaking of the due diligence exercise should have experience in conducting such evaluations and should be very knowledgeable in the applicable regulations. They will be able to spot the red flags that may not otherwise be obvious. It may not necessarily be a matter of deception of the part of the seller, as the seller themselves may not be aware of their own non-compliance or regulatory liabilities. For this reason, it is often the practice of sellers to conduct their own internal regulatory self-evaluation prior to subjecting themselves to outside due diligence review.

Then again, there are those sellers who are not as forthcoming or honest and, having been in the business for years, know how to candy-coat certain regulatory or compliance shortcomings—or disguise them altogether. For example, a company may point to the fact that they are registered with the FDA or licensed by Health Canada, and may even present an audit report from the same showing that they have a compliance rating. As important as it is to take these facts into consideration, there is no guarantee (i) that the government auditors caught everything, (ii) that the company fulfilled their post-audit commitments, or (iii) that laws or other factors did not change since the last audit.

Consider the following scenario, which I have seen played out numerous times: Company A purchases an entire brand from Company B. All of the products in the brand are licensed, have been manufactured at GMP compliant facilities, and there is no record of government enforcement actions ever having been taken against Company B. On the surface everything looks good. Only after the acquisition does it emerge that the product formulas had changed and that the proper government agencies were never duly notified. Consequently, any existing product licences or registrations are now obsolete, all former data to support the safety and efficacy of the products are now obsolete, all supporting quality data (such as stability) is now obsolete, critical and additional testing necessitated by the new formulas is not being conducted, and the labeling and/or advertising does not reflect the new formulas. Bottom line: Company A now finds themselves selling an illegal product, and one can only imagine the potential costs involved in coming into compliance, not to mention surviving the heavy brand name tarnishing.

If you are considering an acquisition of, merger with, or investment in a company within the health and food product industries, don’t be dazzled by any marvelous brickwork and fancy wallpaper. Ensure that you engage in proper regulatory due diligence and ensure that you engage those who have the ability and know-how to effectively carry out such an important undertaking.

dicentra provides sought-after guidance on product and marketing compliance, quality assurance and safety standards, research and development, new ingredient assessments and overall regulatory strategies for food and health-related products sold in North American marketplaces. We can be reached at 1-866-647-3279 or info@dicentra.com.